The approaching deadline for Euribor to become compliant with the EU Benchmark Regulation (BMR) is creating significant uncertainty for the euro-denominated floating rate assets and liabilities of structured finance transactions, covered bonds and banks, Fitch Rating says. If Euribor does not become compliant, the benchmark could no longer be used as a reference rate for new contracts from the start of 2020 and could only be used for legacy contracts with regulatory approval.
The Belgian Financial Services and Markets Authority is not expected to assess whether Euribor, which is in the process of being reformed, will become BMR compliant until late 2019. Euribor’s planned hybrid calculation method is being put in place with the aim of meeting the BMR requirements, but it is not yet clear if the change will result in compliance.
Various sectors could be affected if BMR compliance is not reached. Most eurozone structured finance notes reference Euribor, as do a substantial amount of covered bonds issued for repo transactions and euro-denominated bank debt. In contrast, corporate and public sector entities in the eurozone issue floating rate bonds to a lesser extent.
Euribor is also a common reference rate for leveraged and SME loans and commercial mortgages throughout Europe. Most residential mortgages in Finland, Greece, Ireland, Italy, Portugal and Spain are Euribor-based along with smaller proportions in other markets. Shifting to an alternative rate for contracts without long-term fall-back provisions could be particularly difficult given consumer protection laws.
If it does not become BMR compliant, the Belgian FSMA could allow Euribor to continue to be used in legacy contracts. It could also force bank panel participation for up to two years. This would allow some time for an alternative benchmark to be established and adopted by market participants. Work has begun on developing a term rate from a soon-to-be selected alternative euro risk-free rate to become a fall-back or possible replacement rate. But if the ECB’s new euro short-term rate (ESTER) is chosen as the favoured alternative, this two-year period could still be tight as much of the work is unlikely to progress before ESTER’s daily publication starts from 2H19.
If Euribor is deemed BMR compliant, a risk to investors and issuers is that a revised Euribor could have an absolute level or volatility that is different to the current rate. This could see disputes of contracts signed based on the pre-reform Euribor. Increased volatility or different absolute levels could also increase basis risk or prepayment rates, which could affect excess spread for structured finance and covered bonds.
Any potential future rating action for structured finance and covered bonds would depend on how seamlessly Euribor-based bonds, loans and hedges make the transition to either a revised and BMR-compliant Euribor or a fall-back reference rate. The following factors would have an impact on the rating analysis: contractual fall-back provisions, how technical and administrative challenges are addressed, other credit protection and the remaining weighted average lives after 2019 of assets and liabilities exposed to Euribor risks.
Bank and non-bank financial institutions may see non-traded interest rate risks increase if they are unable to re-price their variable-rate loans in line with changes to their funding. But we expect mainstream and specialist lenders should have some scope to pass on any short-term unexpected price adjustments. If replacement term structures do not come on-stream sufficiently quickly or lack liquidity, this could also increase traded market risks. While this could in theory affect capital adequacy requirements or stress-test results, it is likely to be immaterial.
Swaps and swap replacement provisions in structured finance and covered bonds could also be at risk from the tight timeframe for Eonia replacement. Eonia is used for valuations of Euribor-based swaps and will not become BMR-compliant.
